A majority of federal employees say they expect to spend 20 or more years in retirement, according to a new Office of Personnel Management survey. Most also say they want to maintain or raise their standard of living in retirement. With those expectations, employees approaching retirement need to consider their options for converting their Thrift Saving Plan savings into a stream of reliable and regular retirement income.
TSP is the government’s defined contribution retirement plan, similar to the private sector’s 401(k) plan. Many TSP participants, particularly those covered by the Federal Employees Retirement System, will rely on income derived from their accumulated TSP balances to supplement other streams of income and support their standard of living in retirement.
There are two basic options for converting a TSP balance to a stream of regular retirement income: Use the money to purchase an annuity contract, or manage the money in an investment account and take regular withdrawals.
An immediate annuity is an insurance contract that promises to pay a specific, regular stream of income, usually during the annuitant’s life or the joint life of the annuitant and a beneficiary, in exchange for the payment of an initial premium amount, which in this case are the TSP funds.
TSP members have more than one annuity purchase option. A member can purchase a single-life annuity based on his or her own life. Or, a member can purchase a joint and survivor annuity based on the joint life of himself or herself and a survivor beneficiary. Payment will continue, although possibly reduced, following the death of the annuitant and until the death of the survivor.
An optional feature available for a TSP annuity is to get increasing payments — annuity payments that increase each year in response to inflation. If elected, this feature will reduce the initial payment produced by the annuity. The annual increase is limited to 3 percent each year.
Let’s take a look at a TSP annuity calculation undertaken recently on the TSP Web site — www.tsp.gov — and compare it with a managed withdrawal strategy based on my analysis.
- Annuity option: A 65-year-old annuitant with a 60-year-old spouse paying a $100,000 premium for a joint and survivor annuity contract with a 100 percent survivor benefit and the increasing payment option will receive $439 per month or $5,268 per year initially, according to TSP. The value of the annuity contract when both the annuitant and the spouse are deceased is zero.
The annuity can be seen as a good choice because it guarantees a predictable income stream and when combined with the increasing payment option may keep pace with inflation, up to 3 percent per year.
However, the annuity may be risky since it is inflexible. The owner gives up control of and access to the principal. The payments are fixed by the insurance company each year. Also, this election is irreversible, and owners may find that payments may not keep pace with inflation if inflation exceeds the annual 3 percent limit.
- Withdrawal option: The couple retains control of their $100,000 TSP balance and prudently manages it using a balanced investment strategy — 40 percent in the C Fund; 15 percent, S Fund; 37 percent, I Fund; 5 percent, F Fund; and 3 percent, G Fund. In my analysis, they can expect to withdraw about $5,450 per year initially. The withdrawal amount will increase 3 percent each year for as long as either spouse is alive. The range of TSP ending values, after funding the withdrawals for life, is likely to be between zero and $700,000, with a most likely ending value of about $185,000.
The withdrawal option can be considered a good choice because it is flexible, allowing owners to retain control of and access to principal. Additionally, withdrawals can be adjusted to keep pace with inflation; and, if the investments perform well, there may be a large residual value in the end to pass on to a spouse or other beneficiary. And, unlike the annuity option, you can change the game plan later.
However, like all investment funds, there is the risk of mismanagement and circumstances could arise that would cause the fund to exhaust prematurely.
Choosing an option
Many investors fail to recognize the fundamental difference between an immediate annuity and an investment account: With an immediate annuity you irrevocably forfeit your principal and with the withdrawal option you retain access to the principal and have the added flexibility of making a future change.
This confusion is probably due to the fact that there are tax-deferred investment accounts that are also called annuities. However, these are deferred annuities and have little in common with the immediate variety that provides guaranteed income and are offered to TSP participants.
Once the differences between taking withdrawals and buying an immediate annuity are understood, many investors choose the withdrawal option.
The decision about what do with your TSP balance at retirement should be based on your specific circumstances, goals and tolerance for risk.
Remember, the decision to purchase an immediate annuity is an irreversible decision and it is crucial that all of the relevant factors are identified, understood and carefully analyzed. It generally makes more sense to purchase an immediate annuity when:
- It is purchased with a minority share of the total retirement portfolio and is serving much like a fixed-income investment.
- There are doubts about the quality of investment management that will be applied during retirement.
- There is concern over the spending discipline of the beneficiary of the TSP account.
It is also important to remember that the interest rate at the time the annuity is purchased will directly affect its payment stream. Buying an immediate annuity locks in the return on the investment. For this reason, many investors avoid buying annuities when the interest rate is low.
I generally recommend that TSP participants avoid or delay the decision to annuitize their account balances until they have performed a thorough, unbiased and competent analysis.
Written by Mike Miles
For the Federal Times
Publication July 17, 2006